Document Sample
					                                                                                                      ECONOMICS FOCUS
                                                                            INVESTMENT BANKING AND COMMERCIAL BANKING               15

                                INVESTMENT BANKING
                              AND COMMERCIAL BANKING
                          IN THE EU AND IN SLOVAKIA

                                JUDr. Ján Vyhnálik, National Bank of Slovakia

       Certain business corporations in Slovakia, to whom a banking license has not been granted,
   offer services of investment banking and private banking. We therefore deem it necessary to define
       the relationship of both of the mentioned categories to the currently applicable Banking Act
      and other relevant laws. In this context, it is also desirable to clarify the relationship between
                               investment banking and commercial banking.

                  Investment Banking                                rations, corporate finance, mergers & acquisitions,
                                                                    assets management, financing using venture capital,
   Investment banking (hereinafter the "IB") is an eco-             merchant banking and securities transactions for insti-
nomics category, but a completely unequivocal definiti-             tutional investors. This concept of IB does not include
on of its nature is not simple even for any theory of eco-          e.g. retail securities transactions and trading in insu-
nomics. Investment banking is not a legal term and as               rance products.
such this concept is neither defined nor used in appli-               3. Selected capital market operations with emphasis
cable laws or other statutory regulations. It was coined            on issuing operations, mergers & acquisitions and
in response to the specific activity of investment con-             merchant banking.
ducted by banks notably in the securities markets. This               4. The narrowest definition is historically rooted,
was as a result of a prevailing focus on performance of             where once in the past issuing operations and broke-
investment activities and a specific group of investment            rage or dealer trading in secondary markets were dee-
banks were profiled within the banking systems of cer-              med to constitute IB.
tain countries. Nevertheless, investment activities were              P. Musílek defines investment banking as transacti-
also carried out by other specialised institutions, apart           ons in securities, financial derivatives and other instru-
from banks, whereas the term of investment banking                  ments of private financial markets. In his understan-
came to be generally used to refer to this type of ser-             ding, IB comprises: issuing operations, own and
vice, regardless of the type of licensed entities provi-            intermediary trading in investment instruments, custo-
ding them.                                                          dy, assets management and mergers & acquisitions.
   Several definitions of investment banking are in use             Investment banking primarily encompasses intermedi-
in the theory of economics.                                         ary trade for the clients' account, with the main source
   For example, Petr Musílek1 quotes that according to              of profits being brokerage commission, and/or a diffe-
R. Kuhn2 the following four definitions of IB are possib-           rence between the bid and asked prices (unlike com-
le, starting from the broadest to the narrowest one:                mercial banking with prevailing trading for one's own
   1. All the activities of major Wall Street firms - from          account and at one's own risk and the main source of
international issuing operations to retail business, inc-           profits consisting of an interest margin between len-
luding real estate business and trading in insurance                ding and deposit-taking business bearing interest).
products.                                                             Under the Slovak legislation currently in place,
   2. All the activities in capital markets, i.e. issuing ope-      investment banking actually is a set of activities regu-
                                                                    lated under the term of investment services by Act No.
1 Musílek, P.: Finanční trhy & investiční bankovnictví (Financial   566/2001 Z.z. on Securities and Investment Services
  Markets & Investment Banking), Prague, ETC Publishing, s.r.o.     and the Amendment of Certain Laws, as amended
2 Kuhn, R.: Investment Banking. New York, Harper and Row,
                                                                    (hereinafter the "Securities Act"). The conduct of such
  1990.                                                             activities is preconditioned by a license for the provisi-

                                                                                                       BIATEC, Volume XII, 3/2004

     on of investment services from the Financial Market            to the execution of the client's order to acquire or sell
     Authority, which authorises the establishment of               an investment instrument, providing that the lender is
     a securities dealer or a branch of a foreign securities        a party to this deal and the conditions as per the Ban-
     dealer within the territory of the SR (§ 54 of the Secu-       king Act have been met;
     rities Act).                                                      • giving advice on business strategy and consulting
        Pursuant to § 6 of the Securities Act, investment ser-      and services concerning the company amalgamation,
     vices (both principal and auxiliary ones) shall be provi-      merger, changeover or division or the purchase of an
     ded to clients in handling investment instruments under        enterprise;
     the conditions set forth thereunder.                              • taking care of the issuance of securities for issuers
        Investment instruments comprise: shares, bonds,             and services associated with the underwriting, place-
     equity certificates, the so-called substitutable securiti-     ment, the payment of earned income and redemption
     es with the attached right to acquire shares and bonds,        of investment instruments;
     or giving rise to the right to settlement in certain instru-      • advisory services relating to investment in invest-
     ments of payment, securities issued beyond the Slovak          ment instruments;
     territory, to which similar rights are attached as to the         • receiving payments from the client and trading in
     previously mentioned securities, money market instru-          foreign exchange assets in accordance with the Fore-
     ments denominated in both the Slovak and foreign cur-          ign Exchange Act in the scope needed for the provisi-
     rencies, futures contracts also allowing for the financi-      on of major investment services;
     al settlement of obligations arising thereunder, and              • conducting similar activities as in the case of prin-
     related to investment instruments, interest rates,             cipal investment instruments provided securities and
     instruments of payment in both the Slovak and foreign          derivatives are involved that are not investment instru-
     currencies or financial market indices, options for the        ments.
     purchase or sale of underlying investment instruments             From the above mentioned one can infer that invest-
     and instruments equivalent to them also allowing for           ment services are not those activities that may only be
     the financial settlement (options relating to the Slovak       performed on the basis of a banking license, i.e. money
     and foreign currency funds, i.e. currency options, and         deposit taking (associated with the provision of interest
     interest rates options), interest rate, currency and equ-      or other considerations constituting a tax expense) and
     ity swaps.                                                     making loans and advances (based on repayable
        The principal investment services include:                  monies obtained from other persons). On the other
        • the acceptance of the client's order for the acqui-       hand, the Act No. 483/2001 Z.z. on Banks and the
     sition, selling, or another kind of handling of investment     Amendment of Certain Laws, as amended (hereinafter
     instruments and the subsequent transfer of the clien-          the "Banking Act") allows banks and branches of fore-
     t's order with a view to its execution;                        ign banks (hereinafter the "bank") to carry out certain
        • the acceptance of the client's order for the acqui-       investment activities subject to an authorisation to be
     sition or selling of an investment instrument and its          obtained from the Financial Market Authority pursuant
     execution for an account other than the service provi-         to the Securities Act in the capacity of securities dea-
     der's account;                                                 lers, provided that subsequently those activities are
        • the acceptance of the client's order for the acqui-       also stated in the banking license. However, even in the
     sition or selling of an investment instrument and its          Banking Act the concept of "investment banking" is not
     execution for one's own account;                               employed, but the term "investment operations" is
        • the management of a portfolio formed of one or            used instead.
     several investment instruments as mandated by the cli-            The comparison between the content of investment
     ent under a contract on the securities portfolio mana-         banking and the currently applicable legislation clearly
     gement separated from the portfolios of other clients;         indicates that IB does not comprise those (typically)
        • arranging the sale of investment instruments for the      banking activities that may only be performed on the
     issuer when they are issued (i.e. flotation);                  basis of a banking license. Activities expressed by this
        • the acquisition of investment instruments from their      term are in fact activities governed by the Securities
     issuer when they are issued with a view to their selling,      Act under the name of investment services and that
     including an obligation to buy from the issuer not pla-        may be performed solely on the basis of an authorisa-
     ced investment instruments (i.e. underwriting).                tion granted by the Financial Market Authority. Alt-
        Auxiliary investment services include:                      hough the expression of "investment banking" has alre-
        • custody or management of one or several invest-           ady established itself, its use in advertising offers of
     ment instruments;                                              entities that are not banks cannot be considered as
        • making loans or advances to the client with a view        appropriate or right for the following reasons:

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                                                                         INVESTMENT BANKING AND COMMERCIAL BANKING                17
   – concerned is the provision of investment services,          i.e. activities that may only be carried out based on an
and not banking services or operations;                          authorisation granted pursuant to the Securities Act
   – the word "banking" invokes an idea that the adver-          (see the text hereinbefore).
tised activities are offered by an entity with a banking            Offering private banking services in advertisement
license granted to it, which in reality is not the case;         campaigns of entities that are not banks may therefore
   – investment banking falls within the line of business        be considered as inappropriate, even as verging on
of separate specialised banks, and when it comes to              admissibility, namely on the following grounds:
universal or commercial banks, this type of business                – private banking in the first place signifies the provi-
(activities) there is separated, in terms of organisation,       sion of typical banking services, i.e. the performance of
accounting and information flows, from typically ban-            operations requiring a banking license, even though, to
king operations.                                                 a lesser degree, it concurrently also includes the provi-
   The publication of offers of investment banking ser-          sion of investment services; from which it can be furt-
vices by entities to whom a banking license has not              her inferred that:
been granted is therefore misleading, especially if such            – such package of services may always be provided
advertisements do not contain a closer specification of          only by an entity to whom a banking license has been
activities on the offer or at least a word of caution that       granted, i.e. a bank;
in fact they are activities as per the Securities Act and           – in global terms, self-contained banks targeted at
not activities (operations) as per the Banking Act.              the most moneyed kind of clientele are engaged in
                                                                 private banking, and, as for a major part of other
   Private banking                                               banks, the conduct of private banking business is
   Private banking (hereinafter the "PB") also is an eco-        covered by specialised organisational subdivisions
nomics and banking category used in connection with              and employees.
the conduct of banking activities with a historical                 The publication of any offers to provide the service of
background to it. That is to say that it is not a legal cate-    private banking by entities not holding a banking licen-
gory, since the concept of "private banking" has not             se is therefore a possible deception, since such entiti-
been defined in the Slovak system of law or used in              es are not authorised to perform activities requiring
laws or other statutory provisions.                              a banking license.
   Private banking stands for the provision of banking              In conclusion to this section we can briefly note that
services notably to the most lucrative group of clients,         the use of labels "investment banking" and particular-
i.e. individuals or families whose net equity has rea-           ly "private banking" in offered services produced as
ched a certain required value.3 It is more about lending         part of any advertising by entities missing a banking
and less about deposit-taking in comparison to com-              license not only has a misleading effect, but is even
mercial banking, also encompassing the management                a deception (§ 2(2) of Act No. 147/2001 Z.z. on Adver-
of investments or investment funds of the said group of          tisement and the Amendment of Certain Laws and §
clients. It may be performed by a separate bank or               45 of the Commercial Code). Should one of such enti-
a designated subdivision within a bank. In PB, banking           ties actually conduct private banking, unauthorised
operations account for a significant part of services            business would be involved at the end of the day.
provided to the given clientele compared to the volume              Non-banking (licensed) entities should offer invest-
of investment operations rendered (unlike investment             ment services instead of investment banking and they
banking).                                                        should not employ the notion of private banking in their
   By virtue of our applicable legislation, private ban-         services offered at all.
king first and foremost represents the conduct of those
activities that in the SR may only be performed on the              Institutional Arrangement of Investment
basis of a banking license granted under the Banking                   Banking and Commercial Banking
Act (making loans and taking of deposits). The notion
of PB denotes to a decisive extent banking activities,              When it comes to the institutional set-up of interme-
whilst also encompassing certain investment services,            diaries of investment business executing operations in
                                                                 the markets for securities and financial derivatives and
–––––––––––––––                                                  intermediaries of a typical banking business, a distin-
3 For example, according to Michael Atz (Emerging Issues         ction between several models for arrangement of
  Series, Federal Reserve Bank of Chicago, 1999), in the         investment banking and commercial banking can be
  U.S.A. this would mean persons or families with an income of
  at least USD 100 000 or the net equity of above USD 500 000.
                                                                 made. These models, which result from economic, his-
  Certain private banks demand assets suitable for investment    torical, legislative and regulatory as well as political
  in the amount of at least USD 1 million.                       factors, are as follows: a model of universal banking,

                                                                                                     BIATEC, Volume XII, 3/2004

     a model of separate banking, a model of a holding               ge), and bank holdings to hold investment firms as
     company and a model of a subsidiary.4                           subsidiaries. Since then bank lobbyist groups exerted
        A universal banking model is represented by                  strong pressures to abolish the Glass-Steagall Act,
     a banking system in which universal banks concurrent-           which to a certain extent disadvantaged American
     ly pursue both commercial banking (in the banking               banks in international competition. The Financial Servi-
     intermediary market) and investment banking (opera-             ces Modernization Act (the Gramm-Leach-Billey Act)
     ting as an investment firm in the securities market).           of 1999 allowed for the cancellation of barriers betwe-
     Their universal nature is due to the fact that the banks        en commercial banking, investment banking, collective
     take deposits, make loans, trade in securities for their        investment and insurance business, permitting the
     own account, provide for issuing operations, manage             conduct of these activities directly by a financial hol-
     their clients' assets and execute payments. In addition         ding, that is, not just through subsidiaries as until that
     to universal banks, operators in the securities market          time.
     also include independent investment firms. Commerci-               In Japan, investment banking was separated from
     al banking is usually interconnected with investment            commercial banking after the Second World War as
     banking in accounting terms and there is a free flow of         a result of legislative changes following the American
     information between the two organisational subdivisi-           example. There were differences compared to the
     ons of banks. This model is a prevailing model for ban-         American model though. From the end of the 80 's of
     king in the continental Europe, also having been                the last century there was a growing pressure to do
     accepted by Member States of the European Union.                away with the separate banking model. In 1992, the
     The universal model is in principle embodied by a prin-         Financial System Reform Law was passed, which ope-
     ciple of a uniform banking license covering both of             ned a road to the model of universal banking. The
     these basic lines of business.                                  separate banking model should be definitively termina-
        A separate banking model is marked by a distinct             ted through the implementation of measures adopted
     division of commercial and investment banking. Deposit          in 1998.
     and lending business is pursued and payments are exe-              A holding model. A holding is a business corporati-
     cuted by commercial banks, whilst investment operati-           on founded to perform control over one or several com-
     ons are performed by investment banks and likewise by           panies. A bank holding (BH) controls a bank and
     other specialised entities. The separate banking model          investment firm with a subsidiary relationship to each
     was formed because of market reasons (a market                  other. This means that investment activities are carried
     model) or as a result of regulation (a regulatory model).       on by a separate legal entity. A commercial bank must
        In the past, a typical example of a separate banking         be separated from the subsidiary investment firm by
     model was represented by British banking. In the                a "wall" restraining personnel, information and trading
     70's during the 20th century, a gradual transition to           links between the commercial and investment banking.
     a universal banking model or a subsidiary model star-           This model was most highly developed in the U.S.A.,
     ted in British banking.                                         where such companies were already formed during the
        A regulatory model of separate banking is characte-          19th century. They mainly served the purpose of cir-
     ristic of the U.S.A and Japan. As for the U.S.A., com-          cumventing the ban on combination of commercial and
     mercial banking was separated from investment ban-              investment banking.
     king pursuant to the Glass-Steagall Act of 1933, which             The Act on Bank Holdings of 1956 (initiated by the
     was adopted following to a wave of bank bankruptcies            FRS) set forth the rules for foundation and business of
     in 1929 to 1933. It strived to stifle a conflict of interest    bank holdings, i.e. companies holding more than
     resulting from a united commercial and investment               a 25% ownership interest in a bank's share capital. As
     banking and create a less risky banking system.                 a result, also bank holdings became subject to the
     Nevertheless, the borderline between commercial and             Glass-Steagall Act of 1933 and bank holdings were not
     investment banking started to be disrupted in the               permitted to acquire a direct or indirect controlling
     80's of the past century. Regulators (the Office of the         interest in non-banking entities, including investment
     Comptroller of the Currency, OCC and the Federal                companies. In 1987, the FRS allowed adequately capi-
     Reserve System, FRS) permitted commercial banks                 talised bank holdings to own investment firms as their
     and bank holdings to conduct, to a limited extent, acti-        subsidiaries, which could also perform operations for-
     vities relating to securities (operations in securities,        bidden under the Glass-Steagall Act; the revenue from
     mortgage bonds, financial consultancy and brokera-              such operations however could not exceed 25% of the
                                                                     total revenue of such subsidiaries. At the turn of the 80
     4 Musílek, P.: Trhy cenných papírů (Securities Markets). Eko-   's and 90 's of the past century, large American ban-
     press, s. r. o., Praque 2002.                                   king corporations practically transferred to the holding

     BIATEC, Volume XII, 3/2004
                                                                                                    ECONOMICS FOCUS
                                                                          INVESTMENT BANKING AND COMMERCIAL BANKING                 19
model in order to incorporate investment banking.                 investment banking, the banking system in the Slovak
In 1997, the FRS modified the "wall" system by new                Republic also falls under the universal banking model,
rules for operation.                                              nevertheless taking into account the necessity of sepa-
   A subsidiary model is typified by the principle that           rated conduct of these activities. 18 banks and 3
a parent bank only pursues commercial banking and                 branch offices of foreign banks with a universal ban-
concurrently controls a separate legal entity, that is            king license operate in Slovakia. In 2003, they conduc-
a company which pursues investment banking. Such                  ted more than 90% of the total volume of investment
a model can be formed either through regulatory or                services6 on the top of banking operations.
market action.                                                       By way of a banking license, the National Bank of
   The regulatory subsidiary model was introduced in              Slovakia authorises a bank to pursue both lending and
order to limit a conflict of interest between commercial          investment business (§ 2(1&2) of the Banking Act). The
and investment operations. There is a barrier restrai-            granting of a banking authorisation to conduct invest-
ning information, personnel and financial connections             ment activities must however be preceded by the grant
between a parent bank and an investment firm. This                of an authorisation from the Financial Market Authority
model for integrating the investment banking into                 for the provision of investment services under the
a subsidiary investment firm was applied in Denmark               Securities Act, i.e. for the establishment of a securities
and Hungary.                                                      dealer.
   The market subsidiary model is a result of a ban-                 Under the Act, the term of lending business refers to
k's decision, which prefers to transfer investment ban-           activities relating to the provision of loans, including
king or selected investment operations off to a subsi-            guarantees (§ 34(3)). For these purposes, investment
diary, which is a specialised investment firm. This is            business is taken to mean activities related to invest-
primarily driven by a wish for a more effective cost con-         ment in securities, trading in securities, trading in the
trol, the separation of investment risk from commercial           rights attaching to securities or derived from securities,
banking risks and enhancement of trustworthiness of               participation in the issuance of securities and the pro-
the business done by the entire financial group. Over             vision of related services as well as the management
the last years, this model started to be also employed            of securities, including consulting (§ 34(4).
by some European universal banks that have acquired                  Nevertheless, in order to prevent a potential conflict
specialised investment firms (largely of Anglo-Saxon              of interest between commercial banking and invest-
provenience) through acquisitions and integrated them             ment operations of the same bank, the Banking Act
into their financial groups.                                      imposes upon banks an obligation to separate lending
                                                                  operations from investment operations. It sets forth that
 Investment Banking under the Conditions of                       in its Articles a bank is obligated to lay down and divi-
  the European Union, Slovak legislation and                      de powers and accountability for separated conduct of
        the Banking System in the SR                              lending and investment business (§ 23(1e)).
                                                                     Unless publicly accessible information is involved,
  The concept of a universal bank selling a variety of            a bank is not allowed to use information obtained in
services is deep-rooted in Europe.5                               connection with its lending business in conducting
  By virtue of the basic EU banking directive (Directive          investment operations and conversely, it may not
2000/12/EC of the European Parliament and of the                  employ information acquired during investment opera-
Council of 20 March 2000 relating to the taking up and            tions in transacting the business of lending. Likewise,
pursuit of the business of credit institutions), a univer-        a bank is not allowed to use in-house any information
sal model for banking was adopted. It is reflected in the         gained in connection with investment operations per-
principle of a single banking license under which licen-          formed for the account of its client, and also may not
sing (supervisory) authorities of Member States jointly           use in favour of the client any information obtained as
authorise banks to perform both lending and invest-               part of investment operations conducted for its own
ment activities. The list of such activities is annexed to        account. In order to meet these requirements, a bank
the directive.                                                    is obligated to take such measures with regard to its
  In terms of an institutional set-up of commercial and           organisational, management and control system as to

–––––––––––––––                                                   –––––––––––––––
5 For example, approximately 90% of mutual funds here were        6 The major black sheep have already vacated the market. A
  sold by universal banks, whilst in the U.S.A. universal banks     quote from a comment made by S. Šťastný, the Vice-Presi-
  sold about 35% of such funds. (Ježek, K.: Dva modely ban-         dent of the Board of the Financial Market Authority, concer-
  kovnictví v EÚ [Two models of banking in the EU], Bankov-         ning the most frequented complaints in the area of invest-
  nictví, No. 6/99, p. 31).                                         ment (Pravda, 19.2.2004).

                                                                                                       BIATEC, Volume XII, 3/2004

     separate lending and investment business from each          Owing to this development (especially the introduction
     other. Investment operations for the client's account       of euro, declining interests and margins) certain large
     may only be conducted by a bank under the terms and         European universal banks shifted their focus from who-
     conditions favourable for the client, especially at the     lesale to retail banking and the winning of new markets
     price favourable for the client, and taking due professi-   (e.g. in Central and Eastern Europe). As a result of
     onal care. A bank is also obligated to maintain separa-     investment banking becoming more attractive, they
     te records on investments made for its own account          concurrently tried to gain a more significant share in
     and for the account of its clients.                         the investment banking market by building up their own
       Recent years witnessed sustaining and strengthe-          investment operations on the one hand and through
     ning tendencies towards universal banking in Europe.        acquisition of smaller investment banks on the other.

     BIATEC, Volume XII, 3/2004